Friday, July 11, 2008
flaws in FHA bill
One year and one million foreclosures into the mortgage crisis, Congress will finally produce a major piece of legislation aimed at alleviating the problem. The Dodd-Frank FHA Bill will authorize the Federal Housing Administration to insure refinanced mortgages, en masse. FHA-guaranteed mortgage terms will supposedly be more manageable for homeowners than their current ones. Lawmakers can say they've "done something" about the crisis. The only problem is the bill won't work. Contractual and incentive problems in securitized mortgages will defeat the legislation's attempt to provide a significant amount of relief. First, the bill requires lenders to write down the principal on loans by as much as 15%, and waive prepayment fees before their loans are eligible for FHA-guaranteed refinancing. This would be simple enough in the 1950s mortgage market....Today the majority of residential mortgages are held by securitization trusts... For securitized loans, there is no "lender" who can write down the principal. Instead, management of the loan is contracted out to a servicer. Frequently, servicers are contractually forbidden from modifying loans or else significantly restricted in their ability to do so. This alone will prevent many mortgages from being eligible for FHA refinancing. Even when servicers can modify loans, they have no incentive to do so for the FHA program. Servicers incur significant costs (up to $1,600) in modifying a loan. Moreover, servicers' income is mainly based on the amount of principal outstanding in a securitization trust. When a loan leaves the pool because of a refinancing, the servicer ceases to receive revenue from it. Any equity appreciation in the property would be shared by the mortgage holder and the FHA, but not the servicer. In short, servicers have nothing to gain and everything to lose by engaging in the write-downs necessary for the FHA bill to work. Another obstacle: Many homeowners have second mortgages, and many of these second mortgages are completely "underwater" -- or out of money. The second mortgages are frequently held by different entities than the first mortgages. In order for the refinanced mortgage to be insured by FHA, the second mortgage holder would have to be bought out. Underwater second mortgagees (and many might be underwater even after a write-down on the first mortgage), have nothing to lose by holding out for a high payout and will block many refinancings. The FHA bill does not fix this problem. Third, the FHA is not staffed to handle hundreds of thousands of refinancings, and neither are mortgage servicers (if they were willing to cooperate). It will take several months for the FHA program to hit full speed. In the meantime, foreclosures will continue, in the hundreds of thousands. The next Congress, in all likelihood, will have to revisit this problem -- in 2009. The final critical flaw is that the FHA bill puts taxpayer dollars at risk. To the extent that lenders are willing and able to do the write-down necessary for the FHA refinancing, they will only do so for loans that they think are worth less than 85 cents on the dollar. Lenders will retain loans with a higher expected recovery rate. This means there is an adverse selection problem for the FHA refinancing. Lenders will only sell the FHA their worst lemons, so the FHA will be overpaying for bum loans. Lenders' contributions to an FHA loss reserve fund, and a special tax on Fannie Mae and Freddie Mac, are supposed to protect against FHA losses. But no one has a firm idea of how many loans will be refinanced or just what the losses will be on those loans. It's all guesswork, and there's no reason to think that Congress's real estate gamble is going to pan out any better than that of so many investors.Let's hope Congress gets it right. If not, the taxpayers will be holding the bag, mortgage markets will continue to suffer, and many more families will lose their homes.